ceo compensation and bank risk is compensation in banking structured to promote risk taking?

ELSEVIER Journal of Monetary Economics 36 (1995) 405 431

JOURNALOF Monetary ECONOMICS

CEO compensation and bank risk Is compensation in banking structured to promote

risk taking?

Joel F. Houston, Christopher James* Graduate School of Business Administration, University of Florida, Gainesville, FL 326ll. USA

(Received June 1993; final version received October 1995)

Abstract

This paper examines whether executive compensation in banking is structured to promote risk taking. We find that, on average, bank CEOs receive less cash compensation, are less likely to participate in a stock option plan, hold fewer stock options, and receive a smaller percentage of their total compensation in the form of options and stock than do CEOs in other industries. Cross-sectional differences in the structure of compensation contracts within banking are also examined. We find a positive and significant relation between the importance of equity-based incentives and the value of the bank's charter. This result is inconsistent with the hypothesis that compensation policies promote risk taking in banking.

Key words." Financial institutions; Compensation; Government policy

J E L classification: G28

*Corresponding author.

An earlier version of this paper (1992) was entitled 'An Analysis of the Determinants of Managerial Compensation in Banking'. This paper was supported in part by a grant from the Mid-America Institute. The authors would like to thank David T. Brown, Jon Garfinkel, Mike Ryngaert, Greg Udell, and seminar participants at the University of Pittsburgh, University of South Florida, and the BRC/JFI conference on Globalization and Reform of Financial Institutions for their helpful comments.

0304-3932/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved SSDI 0 3 0 4 3 9 3 2 9 5 0 1 2 1 9 E

406 J.F. Houston, C. James/Journal of Monetary Economics 36 (1995) 405-431

1. Introduction

Recently, there has been considerable interest in the determinants of managerial compensation in banking.1 This interest stems in part from bank regulatory concerns with moral hazard problems arising from the provision of fixed rate deposit insurance. Specifically, to the extent that depositors are insured by the FDIC against losses, they will be indifferent to the riskiness of a bank's investment and financing strategies. As a result, bank shareholders will face greater risk-taking incentives than shareholders of other levered firms. 2 Whether the greater incentives for risk taking are reflected in riskier operating strategies will depend upon the effectiveness of incentives provided to bank managers to increase risk as well as the effectiveness of regulatory policies designed to mitigate risk taking.

If management compensation policies are structured to promote risk taking, one would expect compensation contracts in banking will provide managers with greater risk-taking incentives than in other industries. Bank regulators have long recognized this linkage. Recognition of the incentive effects of management compensation is codified in the FDIC Improvement Act of 1991 (FDIC1A). FDICIA provides bank regulators with oversight authority concerning the compensation of senior bank management and requires undercapitalized institutions to receive prior written approval from bank regulators to pay senior management bonuses or to increase senior management's compensation. 3

The compensation provisions in FDICIA were severely criticized by many in the industry. As a result, regulators have been reluctant to adopt strict guidelines limiting compensation policies for healthy banks. However, the regulatory agencies have maintained an interest in compensation policies, and are expected to reintroduce guidelines for determining compensation. 4 Along

1See for example Barro and Barro (1990), Crawford, Ezzell, and Miles (1995), Houston and James (1993), Hubbard and Palia (1995), and Saunders, Strock, Travlos (1990).

2While the option-like characteristics of equity in other levered firms may provide incentives for risk taking, the increased costs of future debt financing and the potentially adverse reputational effects of unexpected increases in risk serve to mitigate shareholders' incentives to expropriate bondholder wealth.

3Regulation in banking has traditionally focused on controlling risk taking through establishing minimum capital requirements and through regulations restricting bank portfolio choice. FDICIA expands regulatory oversight to senior management compensation policies as well. The act also restricts management fees paid to shareholders with a controlling interest in the bank's stock.

4A recent speech by Comptroller of the Currency, Eugene A. Ludwig, raised concerns about risk taking in the industry, and suggested that examiners should investigate whether compensation policies are designed to encourage risk taking. For a discussion of regulator's plan to set guidelines for compensation, see Barbara A. Rehm, 'FDIC Reviving Plan to Shrink Golden Parachutes at Sick Banks', American Banker, March 24, 1995, p. 3, and Barbara A. Rehm, 'FDIC Again Unfurls a Golden Parachute Plan, But with More Leeway', American Banker, January 13, 1995, p. 3.

J.F. Houston, C. James/Journal of Monetary Economics 36 (1995) 405-431 407

many dimensions, concerns continue to be raised about compensation within the financial services industry. The recent collapse of Barings PLC, because of large losses from trading derivatives, raises renewed questions about whether employees are provided incentives to take on exorbitant risks. The eroding distinction between commercial and investment banking suggests that commercial banks will face pressure to adopt compensation policies similar to those found in investment banking, which themselves have been the subject of criti- cism. Finally, many of the dramatic losses resulting from the decline of the Savings and Loan industry in the 1980s can be attributed to policies which failed to limit managerial incentives for risk taking.

Despite the concerns of regulators, promoting risk taking is not the only (or perhaps even the most important) factor influencing the structure of banking compensation contracts. As in other industries, the structure of bank compensation contracts will reflect factors such as the cost of monitoring managers, the nature of the assets managed, the discretion afforded the manager, the regulatory environment, and the firm's investment opportunity set. s As a result, an empirical examination of the influence of compensation on risk taking needs to control for the effects of these other factors on the structure of CEO compensation.

In this paper, we examine the structure and level of CEO compensation in banking and compare CEO compensation in banking to compensation in other industries. Our objective is to examine whether CEO compensation is structured to promote risk taking in banking. We find that, on average, bank CEOs receive less cash compensation, are less likely to participate in a stock option plan, hold fewer stock options, and receive a smaller percentage of their total compensation in the form of options and stock than do CEOs in other industries. Consistent with the recent work of Smith and Watts (1992), we find that banking firms possess fewer growth options, on average, than nonbanking firms. Indeed, we find evidence that lower CEO stock holdings and the less frequent use of option-based compensation in banking than in other industries are due to differences in investment opportunities and other firm characteristics. Finally, in contrast to other studies, we find that on average CEO cash compensation (i.e., salary plus cash bonus) is more sensitive to firm performance (as measured by the stock returns) in banking than in other industries. However, we find no

5For example, Gaver and Gaver (1993), Smith and Watts (1992), and Kole (1993) find higher levels of cash compensation and greater reliance on stock-based incentive compensation for firms with more growth options relative to tangible assets. These studies also find that the reliance on incentive compensation varies with the regulatory environment that the firm operates in. In particular, Smith and Watts (1992) and Mayers and Smith (1993) find that compensation is much less responsive to firm performance in regulated industries than in unregulated industries (evidence they interpret as consistent with greater managerial discretion in unregulated industry!.


significant difference in the overall sensitivity of pay for performance (including noncash compensation) in banking than in other industries. Overall, we find no evidence that equity-based compensation is used to promote risk taking in banking. Indeed, we find that the factors influencing compensation in the banking industry are remarkably similar to those in other industries.

To examine further whether CEO compensation is used to promote risk taking, we analyze cross-sectional differences in the structure of compensation contracts within the banking industry. In particular, we investigate the extent to which proxies for bank risk and bank charter value affect the use of equity-based incentives (i.e., stock and option holdings) in bank compensation packages. We find no significant relation between the reliance on equity-based compensation contracts and measures of bank risk. However, we find a positive and significant relation between the importance of equity-based incentives and the value of the bank's charter. This result is inconsistent with the hypothesis that compensation policies promote risk taking in banking.

We also investigate whether weakly capitalized institutions and banks identified by regulators as 'problem institutions' (by the confidential CAMEL rating) are more likely to employ compensation packages to promote excessive risk- taking (since presumably these are the institutions that receive the greatest subsidy from deposit insurance). We find no significant difference between the compensation packages of undercapitalized or problem institutions and adequately capitalized banks. In addition, we find that banks which were classified by the Comptroller of the Currency as 'too big to fail', did not employ compensation packages that were significantly different from other banks, despite the fact that these large banks were well insulated from regulatory pressure, and therefore have greater incentives for risk taking.

Our results indicate that equity-based compensation is not structured to promote risk taking. However, given the greater sensitivity of cash-based compensation to performance in banking than in other industries, we cannot rule out alternative (and perhaps less observable to regulators) mechanisms to incite manages to take on additional risk. Indeed, Parrino (1992) argues that it is easier to monitor managers in banking than in other industries. This argument suggests that it may be possible to directly control bank managers without relying on the use of equity-based incentives. Consequently, bank managers may be provided incentives for risk taking which are not in the observed structure of the compensation contract.

The remainder of the paper is organized as follows. Section 2 briefly summar- izes the existing literature on executive compensation in banking. Section 3 describes the hypotheses tested and prior research concerning CEO compensation in banking. In Section 4, we describe our sample selection procedure and characteristics of our sample of banks and nonbanking firms. Our empirical results are presented in Section 5, while Section 6 provides a summary of our results and a conclusion.

J.F. Houston, C. James / Journal of Monetary Economics 36 (1995) 405 -431 409

2. A brief summary of the existing literature

The recent literature on bank CEO compensation focuses on two related issues. The first issue is the extent to which compensation policies are used to promote risk taking in order to maximize the value of the put option feature of fixed rate deposit insurance (see, for example, Mullins, 1992; Saunders, Strock, and Travlos, 1990). The approach taken by these studies is to examine cross- sectionally the relation between bank risk (as measured by the variance in common stock returns and/or leverage) and specific components of the CEO's compensation package (for example, CEO stock holdings). The results of these studies are mixed. Saunders et al. (1990) finds a positive and statistically significant relation between risk and the percentage of stock held by the CEO. However, Mullins (1992) argues that Saunders et al. findings are largely attribu- table to their failure to adequately control for bank size.

The second issue addressed in the literature on bank CEO compensation concerns the effects of changes in the regulatory environment on the sensitivity of CEO compensation to bank performance. It is often argued that deregulation has transformed the banking industry over the past decade. To the extent such a transformation affects the nature of the firm's agency problems, we would expect to see shifts in managerial compensation within the industry. 6 Consistent with this view, a contemporaneous study by Crawford, Ezzell, and Miles (1995) finds a marked increase in the sensitivity of bank CEO pay for performance during the past decade? Crawford et al. (1995) attribute this result to deregulation and not to enhanced risk-taking incentives arising from the decline in bank capital during the 1980s.

While the above studies provide valuable insights into the determinants of CEO compensation in banking, they provide conflicting results concerning the relation between both CEO stock ownership and compensation and bank risk taking. In part, this conflict may arise from differences in the methodology used and the way in which compensation is measured. In particular, earlier studies focus on the cross-sectional relation between bank risk taking and individual

6In many respects, this branch of the literature follows from the Contracting Hypothesis put forth by Smith and Watts (1992). This hypothesis argues that the nature of a firm's assets and its investment opportunity set affects the type of agency problems a firm incurs. Financial, investment, and compensation policies are designed in large part to reduce the resulting agency cost. Demsetz and Lehn (1985) make a similar point in arguing that the firm's asset mix determines its ownership and financial structure.

7Hubbard and Palia (1995) examine the relation between interstate banking laws and executive compensation. They find evidence of a stronger pay-for-performance relationship in states where interstate banking is permitted. They attribute this finding to a more active corporate control market in states that permit interstate banking.

410 J.F. Houston, C. James/Journal o f Monetary Economics 36 (1995) 405-431

components of the compensation package. For example, Saunders et al. (1990) examine the relation between bank risk and CEO stock holdings. However, compensation packages incorporate a wide variety of elements including salary, bonuses, and stock holdings as well as a variety of stock option plans. As Kole (1993) points out, focusing on individual components of the compensation package can lead to misleading inferences concerning the overall relationship between pay and performance. While later work by Crawford et al. (1995) examines a number of the components of the compensation package, they also do not view these components as interconnected. In particular, Crawford et al. estimate separately the sensitivity of CEO cash compensation, the value of options granted and stock, and the value of CEO stock and option holdings to firm performance. Overall sensitivity measures are obtained by summing up each of the individual sensitivity estimates. This approach provides unbiased and efficient estimates of the overall pay for performance sensitivities only if changes in the individual components are uncorrelated with one another. As discussed below, our empirical results suggest that this bias is important.

Works by Demsetz and Lehn (1985) and Smith and Watts (1992) raise an additional issue concerning empirical tests of the relationship between compensation policies and bank risk taking. In particular, they argue that the firm's asset mix and investment opportunities influence the firm's ownership structure and compensation policies. However, in analyzing the relation between bank risk taking and compensation and CEO ownership, prior studies do not examine the influence of these factors on the structure of CEO compensation or stock ownership, s For example, Crawford et al. (1995) attribute changes in CEO compensation over time to regulatory changes but do not control for changes in investment opportunities.

A final problem that arises in prior studies of changes in CEO compensation over time is their focus on the relation between compensation and e x p o s t

measures of bank performance (generally bank stock returns). However, e x p o s t

measures of performance may not accurately reflect the e x a n t e risk-taking incentives that bank managers face. 9 Moreover, if CEO salaries exhibit down- ward rigidity (for example, because boards of directors are reluctant to cut salaries in the face of poor performance and rely instead of bonuses to reward

8Another example is Saunders et al. (1990). They examine the relation between the variance in bank stock returns and the percentage of stock held by the CEO. While they control for the asset size of the bank, they do not control for cross-sectional differences in the investment opportunities of the banks.

9For example, consider the case of a CEO with a fixed salary and substantial holdings of out-of-the-money stock options. The overall compensation for this CEO will appear to have little ex post sensitivity to bank performance when the bank is performing poorly. However, ex ante the CEO may have strong incentives to take on risk-increasing projects.

~F. Houston, C. James/Journal of Monetary Economics 36 (1995) 405 431 411

good performance), then the observed pay for performance relation may vary depending on whether ex post stock prices rise or fall. This is a particular concern when examining changes in pay-for-performance in a single industry. Specifically, even if ex ante incentives remain unchanged, measures based on ex

post stock price performance may indicate a change in the structure of compensation if there are trends in industry performance. This problem is a potentially serious one in banking. For example, during the 1986 through 1990 period, the average real return on the bank stocks in our sample (described in Section 3) was - 4.87%. The average net of market return was - 10.26%. In contrast, for the

first half of the decade, the average real return was 22.5% and the average net of market return was 10% in banking. We discuss the implications of this trend in detail below.

In this paper, we use cross-section and time series data to examine the relation between CEO compensation and bank risk taking. Following prior studies, we examine the relation between the use of equity-based compensation and risk taking. However, unlike previous studies, we examine the relation between the structure of compensation and measures of bank risk while controlling for differences in bank investment opportunities and other factors that may influence CEO compensation. Moreover, we examine whether the determinants of compensation in banking differ significantly from the factors influencing compensation in other industries. In the next section, we develop alternative hypotheses concerning the determinants of CEO compensation in banking.

3. Factors influencing the compensation of bank executives

Our analysis focuses on two hypotheses concerning the determinants of CEO compensation in banking. The moral hazard hypothesis predicts the compensation policies in banking are designed to encourage risk taking in order to maximize the put option feature of fixed rate of deposit insurance. Shareholders of levered firms have a call option on the firm's assets which ceteris paribus

provides incentives for risk taking. However, for nonbank firms such actions are likely to rise the long-run cost of debt financing, and therefore may be counter- productive. Whether fixed rate deposit insurance provides additional incentives for risk taking beyond those faced by nonbanking firms is an unresolved issue. 1 o

1°In particular, while with fixed rate deposit insurance the explicit cost of deposit financing is insensitive to changes in bank risk, bank regulators can impose restrictions or costs on bank risk-taking activities that act as an implicit tax on bank risk taking (see Buser, Chen, and Kane, 1981). As a result, it is unclear whether the gains from risk taking in banking are greater than for levered firms in other industries.


Smith and Wat t s (1992) out l ine an a l te rna t ive ( though not necessar i ly com- peting) hypothes is concern ing the de t e rminan t s of compensa t ion . They argue tha t cross-sect ional differences in c o m p e n s a t i o n reflect differences in f irms' inves tment o p p o r t u n i t y sets (which are assumed to be exogenous).~ ~ They refer to this as the contractin9 hypothesis. The moral hazard and contracting hypotheses prov ide different p red ic t ions concern ing the factors affecting the level and s t ructure of C E O c o m p e n s a t i o n in banking . These differences are discussed below.

3.1. Factors affecting the structure o f compensation

Prov id ing bank manage r s with more equ i ty -based c o m p e n s a t i o n (relative to n o n b a n k managers ) is pe rhaps one way to encourage risk tak ing in banking. Given penal t ies for p o o r per formance , r isk-averse bank manage r s whose compensa t ion is largely fixed are unl ikely to engage is r i sk- tak ing activities. How- ever, bank manage r s m a y be encouraged to take on risks if on average such risk t ak ing increases the value of their equ i ty -based c ompe nsa t i on (which is the p r e s u m p t i o n of the mora l haza rd hypothesis) . Equ i ty -based c o m p e n s a t i o n includes s tock ownersh ip and the use of s tock opt ions . In par t icu lar , s tock op t ions enable executives to realize the upside benefits of risk taking, while l imit ing the down-s ide costs. ~2

The moral hazard hypothesis fur ther suggests that differences in c o m p e n s a t i o n policies within the bank ing indus t ry result in par t f rom different incentives for risk taking. I t is well recognized tha t the mora l haza rd p rob l e m is pa r t i cu la r ly acute for banks that are t roub led a n d / o r h ighly levered. M o r a l haza rd p rob - lems m a y also be more p reva len t a m o n g banks tha t have been classified by regula tors as ' too big to fail'. ~ 3 Consequent ly , we should observe higher levels of

11Throughout our anlysis, we are assuming that the nature of the firm's assets and its investment opportunity set are exogenous and that compensation is endogenously determined in part by these factors. While it can be argued that the firm's assets and investment opportunity set are influenced by compensation policies, it would apper that investment opportunity sets and the firm's type of assets are more exogenous than its compensation policies.

12This discussion does not imply that equity-based incentives are undesirable. Indeed, such incentives are a key vehicle for insuring that managers act in shareholder's interest. In many cases, actions which benefit shareholders benefit all of the firm's claimants (e.g., actions which increase the value of the firm's assets). Our point is merely that if deposit insurance creates additional incentives for risk taking which benefits shareholders at the expense of the FDIC, the moral hazard hypothesis would predict that ceteris paribus there be a greater use of equity-based incentives in banking firms.

13in 1984, the Comptroller of the Currency publicly stated that the top eleven banks were 'too big to fail'. This action effectively increased the value of deposit insurance, therefore providing further incentives for risk taking. See O'Hara and Shaw (1990) for a discussion of the wealth effects surrounding this announcement.

J.F. Houston, C. James/Journal of Moneta~ Economies 36 (1995) 405 431 413

managerial stock holdings and /or greater use of stock opt ions for banks that are more highly levered, or classified as either t roubled institutions or ' too big to fail' by regulators. 14

By contrast , the contracting hypothesis would suggest that there would be less equity-based compensa t ion in the banking industry. Smith and Wat ts (1992) argue that regulated industries such as banking face a number of restrictions which limit the investment oppor tun i ty sets of firms within the industry. Their hypothesis suggests that banking firms should have, on average, lower levels of market to book value of assets (which proxies for the level of growth options) and higher levels of leverage. 15 Firms that have more growth options would be expected to have compensa t ion policies that differ from firms that have a greater p ropor t ion of tangible assets. In particular, Smith and Wat ts (1992) argue that it is more difficult to discern the actions and/or the level of effort undertaken by managers of firms that have considerable growth options. This makes it neces- sary to provide incentive-based compensa t ion (such as stock options) to firms with higher growth options, To the extent that banking firms have fewer growth options, we would expect to see lower levels of C E O stock holding and less reliance on stock opt ions in the banking industry. These predictions contrast with those generated by the moral hazard hypothesis.

The pr imary variable used by Smith and Wat ts (1992) to proxy for the firm's investment oppor tun i ty set is the ratio of market to book value of the firm's assets (M/B). It is interesting to note that this proxy for investment opportuni t ies has been interpreted by Keeley (1990) and others as a measure of the charter value of commercial banks. Keeley argues that the possession of a high charter value makes it difficult for a bank to shift losses to the F D I C and the potential loss of available charter when the bank fails is a regulatory bankruptcy cost. This a rgument suggests that banks with higher charter values will have reduced incentives to increase default risk through greater use of leverage or through asset substitution. 16 The relationship between M / B and the use of equity-based

14Crawford, Ezzell, and Miles (1995) examine the relationship between the sensitivity of pay for performance and bank leverage. They find no significant relation between the sensitivity of pay for performance and leverage, evidence they interpret an inconsistent with the hypothesis that compensation contracts promote risk taking in banking.

l SThis is true even in the absence of fixed rate deposit insurance which also provides further incentives for banking firms to increase their leverage.

~6Consistent with Keeley's argument, we find a positive and statistically significant correlation between M/B and the ratio of book equity of bank assets (the Spearman rank correlation coefficient is 0.36, significantly different from zero at the 0.05 level). Similarly, M/B is significantly lower (at the 0.10 level) for troubled banks (banks with CAMEL ratings greater than 2). It is important to recognize that any subsidies from deposit insurance may also increase M/B, However, the fact that M/B is positively and significantly correlated with the ratio of book equity to assets and negatively correlated with CAMEL ratings suggests that M/B is a suitable proxy for charter value.


incentives therefore provides a particularly strong test of whether compensation is primarily explained by the moral hazard hypothesis or by the contracting hypothesis.

3.2. Factors influencing the level o f compensation

The expected marginal product of the CEO is an important determinant of the level of compensation. The marginal product of the CEO is affected in part by his or her abilities, the nature of the firm's assets, as well as the firm's investment opportunity set. In this regard, the contracting hypothesis predicts higher overall levels of executive compensation for firms that have more growth options to the extent it is more difficult to manage firms with wider investment opportunity sets. To the extent that regulation limits the scope of bank assets and investment opportunity sets, we would expect to see lower levels of compensation within the banking industry.

Another consideration is that risk-averse managers will require higher levels of compensation for greater risk taking if managers incur personal costs associated with the increased likelihood of insolvency arising from increased risk taking. To the extent that managers are provided incentives for risk taking in banking, the moral hazard hypothesis would predict ceteris paribus that com- pesation levels would be higher in banking.

3.3. Some provisos

A problem with testing the moral hazard hypothesis arises from the fact that compensation policies as well as bank asset risk and leverage are endogenous. Finding higher levels of compensation (or greater reliance on compensation in the form of options) for riskier banks does not necessarily imply a causal link running from compensation to bank risk. The actions of managers in riskier banks may be more difficult to monitor, or managers of these institutions may have greater value added than managers of relatively safe banks.

Failing to find evidence consistent with the moral hazard hypothesis does not necessarily imply the absence of risk taking incentives in banking. Managers may be induced to increase risk through some mechanism other than the compensation contrat (e.g., direct monitoring by large blockholders or the board of directors). 17 The moral hazard hypothesis refers only to the use of CEO compensation to induce risk taking (which is the rationale behind FDICIA's restrictions on CEO compensation).

* 7parrino (1992) provides evidence consistent with the hypothesis that managerial actions are easier to monitor in banking than in other industries.

J.F. Houston, C. James/Journal of Monetary Economics 36 (1995) 405 431 415

Shareholders may be able to force managers to engage in riskier if managers' actions are fully observable. In such instances, shareholders would not have to rely on incentive compensation. Risk-averse managers, however, would require higher overall levels of compensation if they bear personal costs associated with greater risk taking.

3.4. Other factors influencing compensation

We control for other factors which are likely to influence the level and structure of executive compensation. Specifically, we control for the size of the corporation, the recent performance of the corporation, and the experience of the CEO. The existing theoretical and empirical literature on compensation suggests that we would see a positive relationship between each of these factors and the level of compensation and the use of equity-based incentives.IS To the extent there are fixed costs associated with developing option plans, we would expect to see a positive relationship between firm size and the use of stock options. In addition, given the likely accumulation of options over time, one would expect a positive relationship between the experience of the CEO and the level of outstanding stock options. Finally, Murphy (1986) provides evidence that CEOs are more likely to receive stock options early in their tenure. He argues that this pattern is consistent with the hypothesis that incentive compensation becomes less important for more experienced CEOs where an extensive track record of their value added has been established.

4. Data and sample selection

Our main source of data is the Forbes annual survey of executive compensation. The Forbes survey contains information on CEO salary plus bonus, deferred compensation, the age of the CEO, the number of years that the CEO has been with the company, and the number of years that he/she has served as CEO. In addition, since 1986, Forbes reports CEO stock holdings. The Forbes survey covers 800 CEOs of the largest U.S. corporations.

Our sample covers the periods 1980 through 1990. Using the Forbes surveys we obtained information on CEOs for 134 commercial banks. To be included in the sample, we required that information be available for the bank for the first two years in the sample period. Our sample therefore consists of all commercial banks listed in the Forbes surveys for 1980 and 1981. From the Forbes surveys,

18See Jensen and Murphy (1990) and Rosen (1990) for a review of recent empirical studies relating CEO compensation to firm performance.

416 J.F. Houston, C James/Journal o f Monetary Economics 36 (1995) 405-431

we also collected compensation data for a random sample of 134 nonbanking firms during the same time period.

In addition to the Forbes surveys, we have also collected data for each firm in our sample on stock options granted and exercised and the number of stock options held by the CEO for each year for the period 1982-1988. The chief source of this data is the firm's proxy statements which are part of the SEC file. Option values are estimated using the Black-Scholes methodology. ~ 9 From the proxy statements, we also collected information on management share holding for the years in which these data are available from the Forbes survey. We obtained accounting information for each firm in our sample from Compustat and the Moody's Manuals. In addition, we obtained information on stock returns, total shares outstanding and common stock prices from the CRSP master files. The list of banks that were classified as ' too big to fail' was obtained from O'Hara and Shaw (1990).

For a subsample of 58 of the 134 banks in our sample, we were able to obtain the confidential CAMEL ratings for year-end 1984 through 1989. 20 The CAMEL rating in based on bank examiners' assessments of bank capital, asset quality, management quality, earnings, and liquidity. The overall CAMEL rating is an integer from 1 to 5, with the best being a 1 and the worst being a 5. Banks with overall CAMEL ratings of 4 and 5 are placed on a problem bank list. Banks rated as 3 are considered to be extensively risky and given greater regulatory scrutiny. 21

5. Results

5.1. Characteristics of compensation

Table 1 provides summary statistics for the commercial banks and the nonbank firms in our sample. The commercial banks in our sample are the

19An adjustment is made for continuously compounded dividends. Estimated volatilities are calculated from the variance of daily stock market returns over the calendar year. It is assumed that options granted have 10 years until maturity. The number of options granted is obtained from the firm's proxy statements. The number of options outstanding is generally available from the firm's proxy statements for the earlier years of the sample. For later years, we estimate outstanding options in cases where there is a complete time series available on options granted and exercised.

The firm's year-end share price and dividend payout rates are obtained from the Compustat files. The interest rate on constant maturity Treasury Bonds is from the Federal Reserve Bulletin for various years.

2°The 58 banks are the banks analyzed in James (1988). These are bank holding companies with well-defined load banks and with data available in the Compustant Bank file.

21See Comptroller's Hanclbookfor National Bank Examiners, Sections 500-504, for a discussion of the CAMEL rating and how it is used.

~L F. Houston, C James/Journal of Monetary Economics 36 (1995) 405-431 417

largest U.S. banking firms; the mean and median asset size for the bank sample is $15 and $6 billion, respectively. The mean and median book value of assets for commercial banks is significantly larger than the nonbank firms. 22 However, since banks are more highly levered than nonbank firms, the mean and median book as well as market value of equity for the bank sample is significantly smaller than for the nonbank sample.

Table 1 reveals several differences in the structure of CEO compensation contracts between banking and other industries. First, the mean and median salary in banking are about $100,000 less (in 1980 dollars) than for nonbanking firms (the difference is statistically significant at the 0.01 level). One potential explanation for the lower cash compensation in banking is a lower marginal productivity of managers in banking relative to other industries. In particular, a number of recent studies finds that salaries increase with the size of the firm (see Rosen, 1991, for a summary). Since banks are on average larger (based on assets), the lower levels of cash compensation in banking suggest that ceteris paribus the marginal product of executives is lower in banking than in other industries. This result is consistent with Smith and Watts' (1992) argument that regulation in banking restricts managers' investment discretion thus reducing the marginal product of the CEO.

A second difference in the structure of compensation in banking is that bank CEOs hold less stock and options and are granted fewer stock options per year than nonbank CEOs. 23 In particular, the market value of bank CEO stock and option holdings are about half the value of the stock and option holdings of nonbank CEOs (both the mean and median values are significantly different for the two samples). In addition, the mean and median value of options granted are significantly lower for the banking samples. Finally, although the average market value of equity in banking is smaller than for the nonbank firms, the average ratio of CEO holdings to total stock outstanding is slightly less in banking (although the difference is not statistically significant at the 0.10 level).

As shown in Table 1, the mean and median value of options granted relative to cash compensation is significantly lower (at the 0.01 level) in banking than in other industries. In addition, the value of stock and options outstanding relative to cash compensation (not shown) is also significantly less in banking than in other industries. For example, the average ratio of the market value of CEO stock and option holdings to cash compensation is 6.61 (median equals 0.52) for

22We use a Wilcoxon Sum Rank Test for differences in medians.

23Since in most cases stock options are granted 'at the money', the value of options granted provides a proxy for the number of options granted.

Tab

le 1

Des

crip

tive

sta

tist

ics

for

a sa

mpl

e of

134

com

mer

cial

ban

ks

and

a ra

nd

om

sa

mpl

e of

134

no

nb

ank

fi

rms

list

ed i

n F

orbe

s'

Sur

vey

of E

xecu

tive

C

ompe

nsat

ion,

198

0-19

90

4~

oo

(A)

Ban

k sa

mpl

e (B

) N

on

ban

k s

ampl

e

Fir

m c

hara

cter

isti

cs ~

Mea

n M

edia

n M

axim

um

M

inim

um

M

ean

M

edia

n M

axim

um

M

inim

um

.%

Boo

k va

lue

of a

sset

s (m

illi

ons)

$1

5,04

5 $6

,072

$2

30,6

43

$103

$4

,356

$2

,475

$3

8,89

9 $1

04.5

0 B

ook

valu

e eq

uity

(m

illi

ons)

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94

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0,11

6 $

- 57

4 $1

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18

$16,

335

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2,86

0.00

.~

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arke

t va

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quit

y (m

illi

ons)

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io o

f mar

ket

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ook

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e of

ass

ets

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0.

901

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0.

320

1.29

1.

26

6.58

0.

640

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inc

ome/

asse

ts

0.63

2%

0.76

2%

2.10

%

- 11

.6%

4.

79%

5.

13%

26

.57%

-

41.0

1%

Rat

io b

ook

equi

ty t

o as

sets

0.

06

0.05

8 0.

38

- 0.

07

0.40

0.

41

1.00

-

0.84

A

nnua

l co

mm

on

sto

ck r

etur

ns

16.4

9%

16.4

4%

158.

31%

-

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1%

18.1

1%

15.8

4%

206.

33%

-

87.0

6%

Cha

ract

eris

tics

o

f C

EO

~

Age

56

.25

57

82

36

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59

79

39

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rs a

s C

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ears

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h co

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ny

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0 24

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1

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1

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ary

plus

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0 $4

63.6

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$8

9.50

"~

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) M

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ck

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0

" ho

ldin

gs (

thou

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s of

198

05)

Mar

ket

valu

e of

CE

O o

ptio

n $1

54

$32.

19

$2,3

45

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03

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0 ~

hold

ings

(th

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9805

) b

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ante

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64

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66

$0

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05

0 pe

r ye

ar (

thou

sand

s of

198

05)

Val

ue o

ptio

n gr

ante

d/ca

sh

14.8

5%

0 32

3%

0 37

.46%

5.

0%

1,39

7%

0 co

mpe

nsat

ion

~,

t~

Per

cent

of c

om

mo

n s

tock

hel

d by

CE

O

1.09

%

0.11

9%

42%

0

1.50

%

0.13

%

70.3

2%

0 I

Ann

ual

grow

th i

n re

al C

EO

sal

ary

plus

8.

85%

7.

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18

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--

67.

6%

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%

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%

670%

--

85.

34%

b

on

us

c

"Inf

orm

atio

n on

fir

m c

hara

cter

isti

cs i

s fr

om C

ompu

stat

. C

EO

inf

orm

atio

n is

fro

m F

orbe

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d th

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rm's

Ann

ual

Rep

orts

or

10K

. bE

stim

ated

usi

ng B

lack

-Sch

oles

met

hodo

logy

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alcu

late

d fo

r ye

ars

in w

hich

the

re w

as n

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ange

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the

CE

O.


banking firms. In contrast, the average ratio of stock and option holdings is 41.12 in the nonbank sample (the median is 4.67). These differences are statistically significant at the 0.01 level.

The lower level of cash compensation and the lower levels of option and stock holdings for CEOs in banking are inconsistent with the moral hazard hypothesis. However, these results, together with the lower mean and median M/B in banking, are consistent with the contracting hypothesis which predicts that firms with greater growth opportunities will pay higher salaries and rely more heavily on incentive compensation.

We also analyze the frequency of stock option and formal performance-based compensation plans for the CEO. Our analysis is based on information reported in the annual report and/or 10K filing for 1986. Under the contracting hypothesis, the lower average M/B in banking would be expected to be associated with less frequent use of stock option and performance-based compensation plans than in other industries. Alternatively, moral hazard incentives of deposit insurance would be expected to result in more frequent use of stock option plans. For the bank sample, the proportion of firms with stock option and performance-based compensation is 0.83. For nonbanking firms, the proportion of firms with these plans is 0.86 and 0.83, respectively. The difference in the proportion for the two sets of firms is not statistically significant at the 0.10 level. A similar pattern emerges regarding the frequency of options granted over the period 1982 1988. For 53.61% of the banking observations, there was a positive number of stock options granted. This number was 60.42% for the nonbanking sample excluding utilities. The difference is significant at the 0.05 level. 24

5.2. The use of equity-based incentives

The statistics described in Table 1 indicate that nonbank firms are more likely to rely on equity-based incentives in setting CEO compensation. In Table 2, we report the results of an analysis of the relation between the importance of equity-based compensation and bank and CEO characteristics. Table 3 reports similar results for the sample of nonbanking firms.

The results in Table 2 provide little support for the moral hazard hypothesis. There is no evidence indicating that equity-based incentives (measured by the percentage of stock held by the CEO and by the ratio of options granted to cash compensation) increase the level of risk taking (measured by the variance in stock returns). More important, we find a positive relationship (significant at the 10% level) between the market to book ratio of assets and the use of

Z4Bank CEOs were also granted options less frequently than nonbank CEOs including utility executives. However, the difference between these samples was not statistically significant.


Table 2 Relationship between the structure of CEO compensation and firm size risk characteristics, and the charter value of the bank for a sample of 134 commercial banks, 1981-1990 (t-statistics in parentheses) a

Value options Value options Dependent CEO stock/total CEO stock/total granted/cash granted/cash variable stock outstanding b stock outstanding compenstion ~ compensation

Intercept

Equity/assets d

Variance in stock returns e

Market/book f

Market value of equity g

Years as CEO h

Time > 1985 ~

'Too big to fail '~

R 2

N

0.096 0.0996 2.041 2.155 (4. 729) (4. 613) (1.940) ( 1.923)

-- 0.163 -- 0.1580 -- 1.658 -- 1.508 -- 1.773) ( -- 1.669) ( -- 0.5252) ( -- 0.4504)

- 3.436 - 3.6337 -- 7.164 - 13.2067 -- 1.173) ( -- 1.238) ( -- 0.4605) ( -- 0.7009)

0.0145 0.0147 2.348 2.536 (1.830) ( 1.877) (1.827) ( 1.831)

-- 0.0075 -- 0.0079 -- 0.0058 - 0.0127 -- 4.905) ( -- 4.785) ( -- 0.248) (0.4271)

0.0004 0.0004 -- 0.0063 -- 0.0064 (2.264) (2.266) ( - - 1.963) (1.969)

0.0146 0.0148 0.196 0.1989 (3.6153) (3.647) (2.320) (2.411)

0.0116 0.0449 (0.7642) (0.4150)

0.061 0.061 0.093 0.093

665 665 182 182

"Computed using White heteroskedastic consistent standard errors.

bCEO stock holdings relative to total common stock outstanding are measured at the end of the fiscal year. Information on CEO stock holdings is from the firm's 10K and from Forbes. Information on total stock outstanding is from the CRSP master file.

~The value of option granted is computed using Black-Scholes option pricing fomula. Data on the number of options granted are from the firm's 10K. Information on cash compensation is from Forbes.

dEquity to assets equals book value of equity divided by book value of assets.

eThe variance in stock returns is computed using daily data for the fiscal year. Information for daily stock returns is from CRSP.

f Market/book equals the ratio of market value of assets (computed as book assets - book equity + market value of equity) divided by book value of assets.

gMarket value of equity is computed for fiscal year end using stock price information from CRSP.

hyears as CEO is from Forbes.

iA dummy variable equal to 1 if the observation is for after 1985.

JA dummy variable equal to 1 if the bank is one of the eleven identified as 'too big to fail'.


Table 3 Relationship between structure of CEO compensation and firm size, risk characteristics, and value of growth opportunities for a sample of 134 nonbanking firms"

CEO stock/total Value options granted/ Dependent variable stock outstanding cash compensation ~

Intercept 0.148 - 0.71 (3.10) ( - 0.74)

Equity/assets d 0.011 - 0.94 (0.70) ( - 2.51)

Variance in stock returns c - 4.62 60.69 ( - 0.48) (0.317)

Market/book f - 0.0044 0.33 (0.735) (2.67t

Market value of equity g - 0.01 0.076 ( - 2.94) t1.15)

Years as CEO h 0.002 - 0.011 (4.241 ( 1.52)

Time > 1985 ~ 0.004 0.06 (0.481) (0.507)

R 2 0.055 0.04

N 617 387

aComputed using White heteroskedastic consistent standard errors.

bCEO stock holdings relative to total common stock outstanding are measured at the end of the fiscal year. Information on CEO stock holdings is from the firm's 10K and from Forbes. Information on total stock outstanding is from the CRSP master file.

CThe value of option granted is computed using Black-Scholes option pricing formula, Data on the number of options granted are from the firm's 10K. Information on cash compensation is from Forbes.

dEquity to assets equals book value of equity divided by book value of assets.

eThe variance in stock returns is computed using daily data for the fiscal year. Informatin for daily stock returns is from CRSP.

fMarket/book equals the ratio of market value of assets (computed as book a s s e t s - book equity + market value of equity) divided by book value of assets.

gMarket value of equity is computed for fiscal year end using stock price information from CRSP.

hyears as CEO is from Forbes.

JA dummy variable equal to 1 if the observation is for after 1985.

e q u i t y - b a s e d i n c e n t i v e s . T h i s r e s u l t i n d i c a t e s t h a t b a n k s w i t h g r e a t e r c h a r t e r

v a l u e s a r e m o r e l ike ly t o re ly o n e q u i t y - b a s e d i n c e n t i v e s , w h i c h is c o n s i s t e n t

w i t h t h e c o n t r a c t i n g h y p o t h e s i s a n d i n c o n s i s t e n t w i t h t h e m o r a l h a z a r d h y p o t h -

es is . T h e r e s u l t s in T a b l e 2 a l s o i n d i c a t e t h a t b a n k s w h i c h w e r e c l a s s i f i e d a s ' t o o

422 J.F. Houston, C James/Journal of Monetary Economics 36 (1995) 405-431

big to fail' are no more likely to rely on equity-based incentives, further suggesting the lack of support for the moral hazard hypothesis. 25

The evidence relating bank leverage to the use of equity-based incentives is mixed. While we find a negative (and significant at the 0.09 level) relation between CEO stock holdings and the ratio of book capital to assets, we find no significant relationship between bank leverage and the use of stock options. For nonbanking firms, we find a negative relationship between the reliance on options granted and the firm's equity to asset ratio. However, we find no significant relation between CEO stock holdings and the ratio of capital to assets.

For both banking and nonbanking firms, we find a negative relationship between the market value of equity and the percentage of stock held by the CEO. We also find a positive relationship between firm size and the value of options granted relative to cash compensation. This result is consistent with the notion that the costs of establishing an option plan are more easily borne by larger firms and that larger firms with smaller CEO stock holdings need to rely more heavily an options to align the incentives of managers and shareholders.

For both samples, we also find that the longer the tenure of the CEO, the greater the percentage of firm stock held by the CEO (which is likely to build up throughout the CEOs tenure) and the fewer stock options granted. This results is consistent with existing theory which suggests that the longer the CEO has served, the easier it is to directly observe his or her contribution to firm value, which reduces the need to provide additional stock options to align incentives.

We also address the issue of whether the use of equity-based incentives has shifted over the time period of the sample. The sample is divided into two time periods (1981-1985) and (1986-1990). 26 For the nonbanking sample, there appears to be no change in the use of equity-based incentives. However, in banking there is a greater reliance on equity-based incentives in the late 1980s. This result is consistent with the findings of Crawford et al. (1995)). One explanation, consistent with the moral hazard hypothesis, is that the value of the put option associated with F D I C insurance increased over time which led compensation committees to provide CEOs with more equity-based incentives to encourage risk taking. An alternative explanation stressed by

25The results in Table 2 assume that the top eleven banks were 'too big to fail' throughout the entire sample. We also estimated the results, assuming that banks were not 'too big to fail' until after the Comptroller's announcement in 1984. These results (not reported) are virtually identical to the results reported in Table 2.

26We also considered other break points in the sample. The results were essentially unchanged regardless of where the sample was divided.


Crawford et al. (1995) is that continued deregulation served to expand the investment opportunity sets of banking firms which under the contracting hypothesis would necesitate the additional use of equity-based incentives. 27

Finally, it is interesting to note that the factors influencing the use of equity- based incentives are remarkably similar in banking to those in other industries, For example, we find no significant difference at the 0.10 level (either jointly or individually) in the coefficient estimates relating firm and CEO characteristics to the value of options granted. Using stock ownership, we find that the coefficient estimates for market value of equity and years as CEO are significantly less for the bank sample. However, we find no significant difference in the coefficient estimates for M/B or the risk measures.

On balance, the evidence regarding the use of equity-based incentives appears to be more consistent with the contracting hypothesis. While the use of equity- based incentives has increased over time in the banking industry, these incentives are still a much smaller component of overall compensation for CEOs of banking firms. Moreover, the fact that banks with greater character values rely more on equity-based incentives is strong evidence in support of the contracting hypothesis and against the moral hazard hypothesis. Consequently, the shifts in the structure of CEO compensation over time appear to reflect changing investment opportunity sets as opposed to increased incentives for risk taking.

5.3. The pay for performance relationship

As indicated in Section 2, much of the existing literature has focussed on the observed ex post relationship between firm performance and CEO compensation. Table 4 provides estimates of this relationship for both the banking and nonbanking samples. Two measures of CEO compensation are employed: overall cash compensation (salary plus bonus) and the CEOs' firm-related wealth, which includes the value of the CEOs' stock and option holdings in addition to cash compensation.

Consistent with other studies, there is a highly significant and positive relationship between changes in stockholder wealth and each measure of CEO compensation. Interstingly, we find that the cash compensation of bank CEOs is more sensitive to stock market performance, yet the sensitivity of overall compensation to firm performance is the same for the banking and nonbanking samples. This evidence is consistent with the results in Tables 2 and 3 which

27This argument assumes that M/B represents a noisy measure of the bank's investment opportunities. It is interesting to note that the market to book ratio for commercial banks increases significantly in the last half of the 1980's. Specifically, the mean and median M/B for the banks in our sample is 1.20 and 1.03 for the 1986 through 1990 period. In contrast, the mean and median M/B is 1.02 and 0.81 in the period 1980 through 1985. The difference in the mean and medians is significant at the 0.05 level.

Tab

le 4

Est

imat

es o

f th

e se

nsiti

vity

of

CE

O c

ash

com

pens

atio

n an

d ov

eral

l fi

rm-r

elat

ed w

ealt

h to

cha

nges

in t

he m

arke

t va

lue

of th

e fi

rm's

com

mon

sto

ck f

or

a sa

mpl

e of

134

com

mer

cial

ban

ks a

nd 1

34 n

onba

nkin

g fi

rms,

198

1-19

90 (

t-st

atis

tics

in p

aren

thes

es) ~

Ban

k sa

mpl

e N

onba

nk s

ampl

e E

ntir

e sa

mpl

e

Cas

h co

mpe

n-

CE

O f

irm

-rel

ated

C

ash

com

pen-

C

EO

fir

m-r

elat

ed

Cas

h co

mpe

n-

CE

O f

irm

- sa

tion

b w

ealt

h ~

sati

on

wea

lth

sati

on

rela

ted

wea

lth

f~

Inte

rcep

t $1

6,05

5 $1

01,3

44

$14,

824

$135

,365

$1

5,49

1 $1

27,3

85

(4.7

3)

(2.9

4)

(2.7

8)

(1.1

8)

(4.4

2)

(1.9

7)

Cha

nge

in

0.16

2 1.

421

0.02

3 1.

05

0.02

3 1.

05

~ st

ockh

olde

r w

ealt

h (6

.57)

(4

.15)

(3

.83)

(2

.19)

(3

.89)

(2

.27)

Cha

nge

in s

tock

hold

er

- 0.

0552

-

6.14

,~

w

ealt

h x

'too

big

to

fail'

(

- 1.

39)

(1.6

4)

(Ban

k =

1) x

cha

nge

in

0.10

1 -

0.12

8 st

ockh

olde

r w

ealth

a

(3.5

1)

( -

0.29

6)

,~

R 2

0.

28

0.22

0.

02

0.24

0.

07

0.25

N

590

107

923

122

1514

22

9 ~ k,

a aC

ompu

ted

usin

g W

hite

het

eros

keda

stic

con

sist

ent s

tand

ard

erro

rs.

~,

bCas

h co

mpe

nsat

ion

equa

ls th

e ch

ange

in in

flat

ion

adju

sted

sal

ary

plus

bon

us f

rom

the

prio

r fi

scal

yea

r. C

hang

es in

com

pens

atio

n ar

e co

mpu

ted

for

firm

s w

ith

the

sam

e C

EO

in

adjo

inin

g ye

ars.

Inf

lati

on a

djus

tmen

ts a

re m

ade

usin

g th

e C

PI

inde

x.

cCE

O f

irm

-rel

ated

wea

lth

equa

ls t

he in

flat

ion-

adju

sted

cha

nge

in c

ash

com

pens

atio

n pl

us t

he v

alue

of o

ptio

ns g

rant

ed p

lus

the

chan

ge in

the

val

ue o

f the

C

EO

's s

tock

and

opt

ion

hold

ings

. T

he v

alue

of

opti

on h

oldi

ngs

is c

ompu

ted

usin

g B

lack

-Sch

oles

met

hodo

logy

. I

dCha

nge

in s

tock

hold

er w

ealth

equ

als

infl

atio

n ad

just

ed c

hang

e in

the

mar

ket

valu

e of

com

mon

sto

ck f

or t

he f

isca

l ye

ar.

Coe

ffic

ient

est

imat

es a

re

mul

tipl

ied

by 1

000

for

repo

rtin

g co

nven

ienc

e.

eDum

my

vari

able

whi

ch e

qual

s 1

if th

e ba

nk w

as c

lass

ifie

d as

'to

o bi

g to

fai

l'.

J.F. Houston, C. James/Journal of Moneta~ Economics 36 (1995) 405-431 425

indicate that the structure of CEO compensation is different within the banking industry. Despite the fact that banks rely less on equity-based incentives, overall bank CEO compensation is just as sensitive to firm performance because changes in cash compensation are more sensitive to performance in the banking industry. Again, these results appear to be consistent with the contracting hypothesis. Arguably, growth opportunities are more limited in banking which is likely to make it easier to directly observe the marginal product of the CEO and reduce the need to rely on equity-based incentives. We also find that there is actually a weaker pay for performance relationship among the 'too big to fail' banks. This again suggests that compensation is not designed to promote risk taking, and provides support for contracting hypothesis.

We also test whether there was a shift in the pay for performance relationship in banking over the sample period. Table 2 indicates that there was a significant increase in the use of equity-based incentives after 1985. Presumably, this shift would ceteris paribus result in a stronger relationship between compensation and performance. However, the results (which are not reported in the table) suggest that there has been no increase in either of the estimated pay-for- performance relationships in banking after 1985. This result is different from the result reported in Crawford et al. (1995). There are at least two possible explana- tions for this apparent inconsistency. First, even though equity-based incentives increase after 1985, they still represent a relatively small portion of overall compensation for the median bank CEO, and thus their increase does not lead to an overall increase in sensitivity to performance. A second explanation relates to the ex post time series pattern of bank stock market returns in the post-1985 period. As discussed earlier, bank stock returns on average are negative during the 1986 through 1990 period (the average real return for banks in our sample is - 4.87% verses 22.5% in the pre-1980 period). To the extent that compensation

packages limit the downside exposure of the CEO, bank CEO compensation may be less sensitive to firm performance in declining markets. This effect may offset the increased use of equity-based incentives over this time period. More- over, this possibility highlights the drawbacks of relying solely on ex post pay for performance relationships to draw inferences regarding the determinants of executive compensation? 8 Such estimates need to be interpreted in light of the evidence regarding the ex ante structure of executive compensation which is detailed in Tables 1-3.

5.4. Evidence concerning managerial turnover

The willingness of managers to take on risk depends on the rewards for risk taking as well as the management-borne costs of poor performance. One way

ZSThis possibility also highlights the problem of not viewing the components of compensation as part of an interconnected package.

426 ,~F. Houston, C. James/Journal of Monetary Economics 36 (1995) 405-431

to promote risk taking in banking would be to reduce penalties for poor performance through, for example, a lower likelihood of being fired conditional on poor performance. This argument suggests that if managers have greater risk-taking incentives in banking, there should be a lower managerial turnover in banking, and that bank managers are less likely to be fired for poor performance. Indeed, several recent papers (see, for example, Gorton and Rosen, 1995; Brickley and James, 1987) argue that the lack of an active takeover market in banking together with the provision of deposit insurance (which mitigates outside creditors' incentives to replace management) leads to greater managerial entrenchment in banking. However, Houston and James (1992) find CEO turnover rates among poorly performing banks virtually identical to turnover rates for poorly performing firms in other industries. In addition, Houston and James find management-borne costs of poor performance (in terms of lost wages) virtually the same for bank and nonbank firms.

To investigate the frequency of CEO turnover between the banks and nonbanks in our sample, we compute CEO turnover rates for the firms in our sample. A CEO turnover is defined as a situation where the CEO is replaced in a given year. Since Murphy (1985), Warner, Watts, and Wruck (1988), and Jensen and Murphy (1990) find that the frequency of CEO turnover depends on the age of the CEO, we compute turnover rates for all CEOs and for all CEOs who are 60 years old or younger.

The frequency of CEO turnover for the bank and nonbank firms in our sample are presented in panel A of Table 5. For CEOs in all age groups, turnover rates are virtually identical for banks and nonbanks. In particular, the frequency of turnover for a sample of banks and nonbanks is 13.8 % and 13.9%, respectively (the difference is not statistically significant at the 0.10 level). 29 While the frequency of turnover among younger CEOs (i.e., 60 years or younger) is lower for the sample of banking firms than in the sample of nonbanking firms, the difference is not statistically significant (X 2 = 0.86). The results in panel A are inconsistent with the hypothesis that bank CEOs are more entrenched than CEOs in other industries.

To investigate further the relation between CEO turnover and firm performance, we estimated the following logistic regression:

Prob(Turnover) ] = In 1 - Prob(Turnover)] a + bl Net of market returns

+ bz Return on assets. (1)

In estimating the logistic model, the dependent variable is set to equal one if the CEO is serving his/her last full year, zero otherwise. Net of market returns is

29Jensen and Murphy (1990) report a turnover rate of 10.9% over the period 1974 through 1986.


Table 5 Analysis of turnover frequency and the determinants of turnover for a sample of 134 commercial banks and 134 nonbank firms listed in Forbes' Survey of Executive Compensat ion, 198~1990

Panel A: Turnover frequency

Bank Nonbanks

Frequency of departure a 0.139 0.138

Frequency of departure for age < 60 years 0.090 0.109

Panel B: Relation between CEO turnover and firm performance; estimates of a logistic regression relating CEO turnover to net of market stock returns and accounting earnings (t-statistics in parentheses)

Banks Nonbanks

Full sample CEO < 60 yrs old Full sample CEO < 60 yrs old

Intercept - 1.83 - 2.183 - 1.58 - 1.78 ( - 11.93) ( -- 10.29) ( 12.13) t -- 10.24)

Net of market - 1.59 - 1.46 - 0.08 - 0.20 return h ( - 3.61) ( - 2.35) ( - 0.27) ( 0.47)

Return on assets c - 26.24 - 40.65 - 5.26 - 6.93 ( - 1.69) ( - 1.95) ( - 2.83) ( - 2.83)

Sample size 823 535 920 528

Number of turnovers 111 49 126 57

Pseudo-R z 0.05 0.04 0.(13 0.03

"CEO departure is defined as the replacement of a CEO in a fiscal year. Departures are defined for firms with information reported in the Forbes Survey for consecutive years.

bNet of market returns equal the firm's stock returns less the return on an equally weighted portfolio of NYSE/AMEX stocks.

CReturn on assets equals net income divided by the book value of assets.

d e f i n e d a s t h e d i f f e r e n c e b e t w e e n t h e f i r m ' s s t o c k r e t u r n i n t h e f i s ca l y e a r a n d t h e

r e t u r n o n t h e C R S P e q u a l l y w e i g h t e d p o r t f o l i o o f N Y S E a n d A M E X s t o c k s .

J e n s e n a n d M u r p h y (1990) , W a r n e r , W a t t s , a n d W r u c k (1988) , a n d B a r r o a n d

B a r r o (1990 ) f i n d a n e g a t i v e r e l a t i o n b e t w e e n n e t o f m a r k e t f i r m p e r f o r m a n c e

a n d t h e l i k e l i h o o d o f C E O d e p a r t u r e . 3° Return on assets is d e f i n e d a s t h e n e t

i n c o m e o f t h e f i r m in t h e f i s ca l y e a r d i v i d e d b y t h e y e a r - e n d b o o k v a l u e o f a s s e t s

3°We also include lagged values of the performance measures. The results including lagged values for the performance measures are similar to those reported in Table 4,


for the firm. We expect an inverse relation between accounting earnings and the probability of CEO departure.

Estimates of the logistic regression relating turnover to firm performance are presented in panel B of Table 5. Consistent with the results of previous studies, we find for the sample of commercial banks a negative and statistically significant relation between firm performance (measured by net of market returns and accounting returns) and the probability of CEO turnover. For the sample of nonbank firms, we also find a negative relation between firm performance and CEO turnover. More important, we find no significant difference in the sensitivity of turnover to firm performance between the bank and nonbank samples. In particular, while the estimated coefficient on both the net of market return and the return on assets is less for the sample of banking firms, when we combine the samples of bank and nonbank firms, we fail to find a statistically significant difference in the relation between turnover and firm performance. 3~ The results reported in Table 4, therefore, do not suggest that CEOs in banking are more insulated from the consequences of poor performance than managers in other industries.

5.5. Compensation policies at troubled banks

The preceding comparison of compensation in banking and other industries suggests that compensation contracts are not structured to provide greater incentives for risk taking in banking. However, bank regulators may still be concerned about compensation policies if for the subset of undercapitalized or excessively risky institutions' compensation policies provide management with incentives to exploit the risk-taking incentives of deposit insurance.

We identify troubled banks by utilizing the bank's CAMEL rating. For a subsample of 58 of the 134 banks in our sample, we were able to obtain the bank's CAMEL ratings over the period 1984 through 1987. Using this CAMEL rating, we identified institutions with CAMEL ratings of 3, 4, and 5 as 'problem' or 'potential problem' banks. Using the CAMEL ratings, we were also able to determine the institutions that were downgraded by bank regulators (i.e., institutions identified by regulators as having increased default risk). Using this information, we examine whether the structure of compensation varies with the regulator's appraisal of bank risk.

31We test for a difference between banks and nonbanks by pooling the two samples and estimating a logistic regression over the pooled sample. We include in the regression a set of interactive dummy variables that equal net of market returns or the return on assets if the observation is from the bank sample, zero otherwise. While the estimated coefficients are negative, the difference in the coefficient is not statistically significant at the 0.10 level.


Table 6 Difference in salary, option holdings, and stock holdings between banks not receiving a CAMEL downgrade and banks receiving a downgrade to a 3 or a 4

Mean difference Mean difference Mean difference for year prior to for year of for year after CAMEL change CAMEL change CAMEL change

Option granted/cash 0.06 0.02 0.165 compensation

CEO stock holding/total - 0.02 0.002 0.001 stock outstanding

CEO cash compensation $2.68 $ - 28.02 $ - 22.68 (thousands)

The majority of the banks in our sample have CAMEL ratings of 1 or 2. Specifically, 19% and 60% of the sample observations consist of banks rated 1 or 2 by regulators. Only 13% and 8% of the sample consist of banks rated 3 or 4. None of the banks in our sample were rated a 5. In addition, 9 of the banks in the sample had their CAMEL downgraded to either a 3 or 4 during the sample period. 3z Using these banks, we computed the difference between CEO cash compensation, the percentage of stock held by the CEO, and the ratio of options granted to cash compensation for banks not receiving a downgrade and those receiving a downgrade. The difference in salary and security holdings was computed over the year prior to the CAMEL rating change, the year of the rating change, and over the year following the rating change. If CEO compensation is used to induce banks to pursue risk-increasing policies, one would expect higher levels of salary, a greater ownership share, and more options granted in the years preceding the change in CAMEL rating.

The mean difference in compensation levels around CAMEL rating changes are reported in Table 6. Notice that neither before nor after the rating change is there any significant difference in cash compensation or in stock holdings or options granted between the two sets of banks. This result is inconsistent with the moral hazard hypothesis that predicts that banks that take on more risk (and therefore are more likely to have their CAMEL rating downgraded) pay higher levels of compensation and rely more heavily on incentives such as stock options. Second, these results suggest that the structure of executive compensation does not appear to provide an 'early warning' of trouble ahead.

32Information on CAMEL ratings is confidential. We were able to obtain this information by agreeing to maintain the confidentiality of the CAMEL ratings.


6. Conclusion

We find little evidence that compensation policies in banking are designed to encourage excessive risk taking. To the extent that bank managers are not provided with incentives to engage in risky activities, this may imply that the moral hazard problem in banking may not be that severe. We find that factors influencing compensation and turnover policies in banking are remarkably similar to the factors influencing such policies in other industries.

Nevertheless, we do find that compensation packages tend to be structured differently in the banking industry. Bank managers receive on average less cash compensation as well as fewer equity-based incentives. However, the cash compensation of bank managers is actually more sensitive to firm performance than it is in nonbanking industries. We argue that differences in the structure of compensation between banks and nonbanks as well as within the banking industry can be explained in large part by the nature of the firm's assets and investment opportunity set, which have a profound influence on the type of agency problems that a particular firm faces. Consequently, our results lend additional support to the contracting hypothesis established by Smith and Watts (1992).

Our result that compensation policies are not designed to promote excessive risk taking in banking suggests that attempts by regulators to control compensation in banking are likely to be ineffective. However, we cannot rule out the possibility that bank managers are provided inducements for risk taking through mechanisms other than equity-based incentives or that other (non-CEO) officers and employees are provided incentives for risk taking.

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ceo compensation and bank risk is compensation in banking structured to promote risk taking?

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